Well, I tried with an avi file - using shell compress and encrypt - PA compressed to zip and then gave password prompt. I entered one and pae file was created.

Then still in same explorer window, I selected shell extract to {filename as folder}

PA asked for password, I entered an incorrect password.

PA then “appeared” to extract the file (progress displayed and even creating folder) but on completing gave the message “incorrect password” and deleted the destination folder.
Didn’t have chance to check if (temporary) file was extracted into the folder before deletion.

Is this false extraction process necessary, or should it be immediately cancelled with incorrect password?

it should snot even atrt the process of extractimng if its the wrong password

Eh, its checking the password by extracting the file. Since password is wrong, extracted file is garbage and it gets deleted.

While we could have done password checking via stored hash of the password which would be still considered secure and very fast, this way dictionary based attacks are much, much slower and raise passive security of the pae files up a notch.

It also might help in the future because if some hashing algorithm gets cracked completly, it can not be used to recover the data.